Consumer Banking Today: How Long Will the Good Times Roll?

Interest rates are on the rise again, the equity markets have rebounded and large bank mergers are once again the growth strategy of the moment. Professional tea-leaf readers are starting to worry about retail banking.

Although retail bankers have demonstrated strong revenue performance over the past two years, professional tea-leaf readers are starting to worry. In 2002 and 2003, the consumer banking groups within U.S. commercial banks were almost single-handedly responsible for keeping up institutional profitability by providing the lion's share of bank revenue. As Exhibit 1 shows, financial performance in 2002 and 2003 made consumer bankers into heroes at many institutions.

From the perspective of profit contribution, consumer bankers used their collective clout to increase institutional revenue as a result of the confluence of three factors:

Historically low interest rates

Consumer sentiment rejecting risk

Cessation of mergers and acquisitions (M&As)

As a result of these market conditions, commercial banks in the United States experienced notable growth in the two major revenue drivers of institutional profitability -- cheap deposits and fee income. But the tea-leaf readers are wondering if this party can last.

A Confluence of Factors

In reviewing the market factors, it is important to note that historically low interest rates were not a universal panacea for bank profitability -- as commercial bankers will surely attest. Low interest rates fueled an unprecedented volume of mortgage loan refinancing, yet low interest rates also meant compressed margins on commercial loans. Still, the wave of mortgage refinancing that swept the United States had a tremendous impact on institutional profitability as banks generated considerable opportunities for fee income (not necessarily mortgage-related) and witnessed a strong flow of deposits into escrow accounts.

While low interest rates played a huge role in generating retail profits, the second market factor, consumers' aversion to market and investment risk, cannot be overstated. The precipitous crash and burn of the equity markets in the United States during 2001 and 2002 left consumers somewhat skittish and fearful of investment risk. Those consumers with funds to invest were leery of the markets and frequently sought shelter in bank-insured deposit accounts. The propensity of consumers to pursue savings and deposit accounts, coupled with low interest rates, turned retail bank branches into engines for cheap deposits. Consumer bankers were the chief benefactors as consumers abandoned the markets in favor of the safety and security of insured deposits.

Finally, the complete collapse of merger and acquisition activity forced retail bankers to address the issue of organic growth. In 2002 and 2003, M&A activity came to an almost complete halt. Market capitalizations had plummeted along with the equity markets, and few institutions had the resources to pursue new acquisitions in the quest for sustainable growth. Yet new customers and their cheap deposits were flooding into branches, often in response to "free checking" offers. If institutions were to prosper during these difficult years, it meant developing the skills to grow organically. Marketing know-how, customer retention and customer satisfaction took on new urgency as bankers rushed to capitalize on the influx of new customers. Transient, single-service households were feared -- consumer bankers concentrated on building long-term relationships as their only viable growth strategy.